Many people don’t think through questions systematically. That includes very bright people like Dr. Robert Shiller, who said in this article in Fortune, “We should be able to hedge everything from the rising costs of health care and education to national income risk and oil crises.”
Ugh. And this from an esteemed professor at a significant university? And one with which I have sometimes agreed?
I’ve written about this before in some of my market structure articles, where I tried to dig into the difference between natural, hedging, and gambling exposures. I’ll use an ordinary example to illustrate this: the bankruptcy of IBM.
I use IBM as an example because it is so unlikely to go under. But who would be directly affected if IBM went under?
- Stockholders, both preferred and common
- Banks that have loaned money
- Trade creditors
Let’s talk about the bondholders. They could buy protection via credit default swaps [CDS] to hedge their potential losses. In order for that to happen a new class of risk-takers has to emerge that wants to take IBM credit risk, that don’t own the bonds already. It’s not always true, depending on the specualtive nature of the market (and synthetic CDO activity), but one would suspect that those that want to take on the risk of a default of IBM would only do it at a concession to current market bond pricing, or else they would buy the bonds and pay fixed, receive floating on a swap.
But often the amount of CDS created exceeds the amount of debt covered. I’m not suggesting that everyone owning bonds has hedged, either, but when the amount of CDS exceeds outstanding bonds, that means there is gambling going on, because it means that there are market players that are not long the bonds that are taking the side of the trade where they receive income in the short-run if the company survives, and pay if the company fails.
I call this a gambling market, because there are parties where the transaction takes place where neither has a relationship to the underlying assets. There is no risk transfer, but only a bet. My view is such gambling should be illegal, but I am in a minority on such points.
Now think about another asset: my house. Aside from being somewhat dumpy, beaten-up by my eight kids, the house has a virtue — I live in it free and clear, with no debts to anyone, so long as I pay my property taxes. So what is there to hedge here? I’m not sure, maybe future property taxes?
Aside from the county, and my insurance company, I’m not sure who has a real interest in my house. If I knew that there were many people betting on the value of my house, I might become concerned. What actions might people take against me in bad or good times?
But maybe no one would have interest in my house. It’s just one house, after all. Who would have a concentrated enough interest in it to wager on it?
Now, some would say, we don’t have an interest in your house specifically, but we do have an interest in houses on average in your area. That’s fine, but there is no one with a natural exposure to all of the houses in my area, aside from the county itself.
This is why I think that most real estate derivatives involve gambling. There is no significant natural exposure hedged. It is only a betting market.
And such it would be for most real assets. Few would want to create markets where the owner know more than they do, or, where there a few options for gaining control if things go bad.
At the end of the day, all of the assets of our world are owned 100%. Everything else is a side-bet. Personally, I would argue that the side bets should be prosecuted and eliminated, which would bring greater stability to the economic system. No tail chasing the dog. Let derivative transactions go on where here is real hedging taking place; away from that, such transactions are gambling, and should be illegal.
To Dr. Shiller, many markets are thin. The concept that everything can be hedged assumes deep markets everywhere, which is not the case. Time for you to step outside the university bubble and taste the real world. It’s not as hedgeable as you might imagine.